Investment Insights: It Was A Matter of Time
The domestic equity market experienced a significant sell-off on Thursday, June 11 as the S&P 500 (S&P) fell 5.9%. This marked the third down day in a row for the index. As of June 8, the S&P had gained 44% from its bottom on March 23 based on a trifecta of monetary/fiscal stimulus, re-openings (as a result of declining COVID-19 case data), and economic green shoots.
The catalyst for Thursday’s sell-off appears to be a collective realization that the domestic equity market was getting ahead of itself. In addition, a growing concern over a second wave of COVID-19 cases and its potential negative impact on economic activity is weighing on investors. This was enough to stop the market’s rapid upward momentum. Against this backdrop, it was a matter of time before investors took a breather.
Broadly speaking, we expect monetary/fiscal stimulus and re-openings to continue to support economic activity and markets over the longer term. However, we’re anticipating more volatility as uneven virus and economic data weigh on investors. In the interest of achieving a balanced investment approach, several other asset classes, which have not performed as well as the S&P recently, may be poised for better times ahead.
S&P 500 Valuations, Technicals and Fundamentals
We believe that prior to June 11, valuations were getting ahead of fundamentals. As just one illustration, the following exhibit shows that the S&P’s daily price movements deviated greatly from a higher historical connection relative to earnings (i.e., S&P earnings per share). Our view is that the S&P had rebounded so significantly as to be trading at pre-COVID-19 or optimistic future fundamental levels. Naturally, with current economic momentum picking up, future earnings could close the gap. However, the size of the gap is what’s most important.
Exhibit 1: S&P 500 Price Disconnected from Fundamentals
Source: Bloomberg, As of May 31st 2020. Past performance does not guarantee future results. S&P 500 Index is represented by the S&P 500 Index. The S&P 500 is considered generally representative of U.S. equity market. Trailing 12-Month Earnings reflects the amount of earnings that the S&P 500 index has generated over the last twelve months. The charts reflects the growth in trailing earnings per share for the S&P 500 in relationship to the price of the S&P 500 index.
Prior to Thursday’s sell-off, the market was trading at lofty earnings expectations for 2021. While valuations based on highly variable earnings numbers seem concerning, we note that longer-term discounted cash flow assumptions for the S&P are generally more constructive.
COVID-19 Cases & Re-Openings
Recently, COVID-19 cases have increased in several states, but this should be expected. According to ISI Evercore (ISI), U.S. cases increased on Wednesday to 20,430, which was less than the 7-day moving average. ISI also cites several other positive trends based on data as of June 10, including:
- Daily tests have been increasing (approximately 460,000 7-day average)
- Positive test rates below 10%
- ICU and hospitalization rates on longer-term declines
Some estimates are now predicting a second wave of COVID-19 cases. While this would be an awful outcome, plans to re-open most sectors of the U.S. economy are unlikely to stall. On that note, Treasury Secretary Mnuchin stated on Thursday that the U.S. economy shouldn’t shut down again even if COVID-19 resurges. In terms of the virus’ economic impact, economists suggest that the mortality rate is much more important than the total number of cases. It will also be important to watch hospital utilization rates so that we don’t overwhelm our now better-prepared healthcare system.
Ultimately, the number and pace of economic re-openings here and abroad are substantial. These positive developments are feeding numerous increases in economic forecasts for the second quarter and 2020 as a whole.
Monetary & Fiscal Stimulus Fostering Green Shoots
The big domestic economic news on June 5 was a surprising 2.5 million increase in non-farm jobs for May, versus expectations for a loss of 7.5 million jobs. Although there may be some updates, this brought the unemployment rate to 13.3%, versus expectations of 19%.
Also of note, government paychecks and unemployment benefits have replaced lost wages. This has translated to an actual increase in disposable income. As many sectors of the U.S. economy remain closed, these resources have not made their way into the economy (i.e., personal spending has declined). The result is that the personal savings rate has shot up from 8% of income to 33%. As the economy reopens, consumers will likely find themselves with spare cash to spend.
However, good domestic economic news has, perhaps, been overshadowed by numerous upticks in international economic activity. The European Central Bank recently increased the size of its pandemic quantitative easing program by 600 billion Euros, extending it through mid-2021. The Eurozone’s combined monetary and fiscal stimulus now matches the U.S. at approximately 44% of GDP. Japan is even higher at over 60%.
Exhibit 2: Combined Monetary & Fiscal Stimulus
Source: Cornerstone; As of June 10th 2020. Represents the amount of fiscal and monetary stimulus as a proportion of the country’s Gross Domestic Product.
We continue to believe that economies will re-open, COVID-19 cases will be at a manageable level, and that monetary and fiscal stimulus may create a floor in markets. Nonetheless, we expect high levels of volatility along the way.
Exhibit 3: 2020 Has Seen the Most Volatility since the Financial Crisis
Source: Bloomberg, As of May 31st 2020. Past performance does not guarantee future results. S&P 500 Index is represented by the S&P 500 Index. The S&P 500 is considered generally representative of U.S. equity market.
The exhibit above shows that the number of 2% daily moves has already surpassed all previous years since 2011 and the annualized rate for 2020 could come close to 2008.
In summary, we found the following quotation prophetic for the present and a reminder of the not-so-comforting times that may be ahead.
“In investing, what is comfortable is rarely profitable.” – Rob Arnott